Why Bernie’s Right About Glass-Steagall

Both
Hillary Clinton and Bernie Sanders are talking tough about Wall
Street reform. But only Bernie Sanders is advocating a reprise of the
1933 Glass-Steagall Act, specifically that section of the
Depression-era act that had prohibited commercial banks and
investment banks from operating under the same roof. Sanders believes
that the repeal of Glass-Steagall in 1999 led to the formation of
banks that became “too big to fail,” contributed to the financial
crisis in 2008—and will lead to another crisis without corrective
legislation.

Most
observers think Sanders is on a quixotic quest and, with Wall
Street’s political power, the chances of any revival of
Glass-Steagall are, like his election to the presidency, slim. Yet
Sanders has a strong argument, one that can be effectively made using
Citigroup, the two-century old bank that, along with other Wall
Street banks, has a history of wreaking havoc on itself and the
economy when it mixes commercial banking with investment banking

The
first instance occurred in the 1920s when Charles “Sunshine”
Mitchell became president of what was then National City Bank. The
bank was the largest in the U.S. and its securities affiliate, under
his aggressive management, had also become the country’s largest
investment operation, with sixty-nine sales offices in fifty-eight
cities. Much of National City Bank’s growth, however, was at the
expense of its growing clientele of unwary investors, who became
victims of shoddy securities offerings the bank originated and, most
famously, the notorious investment pools the bank sponsored in the
Roaring Twenties.

In
1933, long after the 1929 stock market crash and in the depth of the
Great Depression, Mitchell was brought before the Senate Banking and
Currency Committee to explain how investment pools worked and how
National City Bank played a role. First, it turned out, the bank
loaned money to a “pool manager” to facilitate the purchase of a
selected “story stock” by a small group of initial investors.
Then the pool manager planted rumors and bogus news accounts to
entice the general public to purchase the stock at ever increasing
prices. National City’s investment affiliate further aided the pool
manager in its efforts by authorizing the payment of “premium”
commissions to tout the targeted stock. When the stock’s price
reached some level judged unsustainable by the pool manager, the
early investors quietly bailed out, leaving smaller and less informed
investors holding the bag. If those chump investors had purchased
their stock on margin, they likely owed large sums of money in
addition to holding the deflated stock.

And
buying stocks on margin was a practice greatly encouraged by National
City Bank, a major supplier of “broker loans.” When the Federal
Reserve tried to tamp down stock market speculation in 1929 by
limiting the amount of margin debt, Mitchell—himself a member of
the Fed’s board of governors—instructed National City to go
directly counter to the central bank’s wishes by increasing
the high volume of broker loans it was already providing. During the
Senate hearings on the collapse of the stock market, Senator Carter
Glass (the Glass in Glass-Steagall) proclaimed that Mitchell “more
than forty others is responsible for the present situation.”

As
the hearings were being conducted, the Glass-Steagall Act was already
in the works to cleave the securities business from traditional,
deposit-backed commercial banking to prevent future abuses. Financial
institutions that had largely stayed above the fray and ran
respectable businesses felt unjustly victimized by the actions of
miscreant banks. J.P. Morgan, Jr. sounded an ominous warning about
the likely effect of Glass-Steagall on his bank, stating, “If we
should be deprived of the right to receive deposits we should very
probably have to disband a large part of our organization, and thus
should be less able to enter into in the future that important
service in the supply of capital for the development of the country
which we have rendered in the past.”

But
shortly after Mitchell’s damning testimony before the Senate
committee, the Glass Steagall Act sailed through Congress and the
strictures of the act applied not only to National City Bank and
other misbehaving banks, but to all financial institutions. Yet
despite Morgan’s dire protestations, his mighty House of Morgan did
just fine after it was split into J.P. Morgan, the commercial bank,
and Morgan Stanley, the investment bank—and for the rest of the
twentieth century the country enjoyed remarkable economic growth
despite a bifurcated financial system made up of relatively small
banks and investment firms.

But
fast forward sixty or so years, into a more deregulated era, and
bankers once again began echoing Morgan’s arguments on the need for
large, integrated financial institutions for the U.S. to remain
competitive in the global economy. Consequently, the Federal Reserve
relaxed many of the provisions meant to enforce Glass-Steagall, and
its chairman at the time, Alan Greenspan, stated in a private
conversation that he would have no problem in principle approving a
merger between a commercial bank and an investment bank—as long as
Glass-Steagall was repealed.

The
other person in that private conversation was Sandy Weill, who had
put together a major financial conglomerate called Travelers Group,
made up of some of the leading insurance and investment firms of the
day, and who had set his sights on acquiring a large commercial bank.
Emboldened by Greenspan’s favorable view, Weill forced the issue in
1998 by negotiating a $70 billion merger of Travelers Group with
Citicorp, the commercial bank that was the outgrowth of National City
Bank. He then undertook a full-court lobbying effort with members of
Congress to repeal Glass-Steagall in order to make the combination
legal. Using Morgan’s earlier arguments centered on competitiveness
in the world economy, both the House and Senate came on board.
President Bill Clinton, who initially withheld his support of the
repeal, was reportedly turned around on the issue at the last minute
by Weill and eventually signed the Financial Services Modernization
Act of 1999—and Glass-Steagall was no more.

The
combined operation that became Citigroup was initially managed by
co-CEOs—Weill from the Travelers side and John Reed from Citicorp.
It would be hard to find two more divergent management styles than
theirs. Reed was a traditional commercial banker whose long-term
mission was to continue developing Citicorp into the world’s
premier global bank. Weill had a very different style. When asked
about his philosophy of strategic planning, Weill replied, “I get
up in the morning, I read the Wall Street Journal, and I make a
strategic plan for the day.” In the inevitable struggle for the top
position, Weill beat out Reed—and a new era of rapid growth,
further acquisitions, and risk taking took hold at Citigroup.

Weill
reluctantly retired in 2003, but his successor, Chuck Prince, was, if
anything, more aggressive and risk prone in combining the commercial
banking side of the business with the investing side. In 2007, when
asked about the bank’s $100 billion leveraged lending program to
support private equity deals, he remarked, “When the music stops,
in terms of liquidity, things will be complicated. But as long as the
music is playing, you’ve got to get up and dance. We’re still
dancing.” He likely had the same view about the housing markets at
a time when Citigroup was originating large numbers of mortgage loans
as a lender and then packaging and selling them in the securities
markets as a broker. But the music indeed stopped the next year and
to prevent the bank’s collapse—and the national economy with
it—the U.S. government wound up backing over $300 billion of
Citigroup assets and making a direct injection of $45 billion in its
equity account.

With
a more watchful regulatory environment and the reforms in place
following the passage of the Dodd-Frank Act in 2010, Citigroup and
the other Wall Street banks have been behaving much better. But
commercial banking and investment banking remain very different
cultures and letting them continue to operate under the same
management represents a triumph of hope over experience. The next
crisis will not likely involve bank financing of investment pools, or
making undo amounts of margin finance available to brokers, or making
high leverage loans to finance equity investments, or originating,
packaging, and selling low-quality mortgage loans. And it may not
involve Citigroup. But, absent a new version of Glass-Steagall, there
will very likely be something just as calamitous. As the quip
attributed to Mark Twain goes, history doesn’t repeat itself, but
it rhymes.

Bernie’s
probably right on this one. Even Sandy Weill—who once was proud to
be referred to on Wall Street as the “Shatterer of
Glass-Steagall”—now seems to agree. In a 2012 interview on CNBC
he said, “What we should probably do is go and split up investment
banking form banking. Have the banks do something that’s not going
to risk the taxpayer dollars, that’s not going to be too big to
fail.”